Chapter 16 Mutual Funds, Insurance Companies, Investment Banks, and Other Financial Firms McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

 Learning Objectives   To explore the many roles played by mutual funds, insurance companies, investment banks, finance companies, mortgage banks, and security dealers.  To discover the different services they offer.  To examine their principal sources and uses of funds.  To understand the many problems they face today. 16-3

Introduction  We now turn to a highly diverse group of financial institutions that attract savings mainly from individuals and families and, for the most part, make long-term loans in the capital market. 16-4

Mutual Funds (Investment Companies)  Mutual funds, or investment companies  Direct the savings of individual investors  Into bonds, stocks, and money market securities  Small savers can buy fund shares  Gains opportunities for capital gains  Access to higher yielding securities  May only be able to purchase in large blocks  Yet still enjoys price stability, low risk, and high liquidity 16-5

Mutual Funds (Investment Companies)  Investment companies first developed in the U.K.  Made their appearance in the U.S. in 1924  A vehicle for buying and monitoring subsidiary corporations  Currently close to half of all American households own shares in mutual funds 16-6

Mutual Funds (Investment Companies)  Since then, the traditionally stock- investing industry has seen many innovations  Bond funds  Money market funds  Index funds  Exchange-traded funds  Global funds  Vulture funds  Small/mid/large-cap investment companies  Hedge funds 16-7

Mutual Funds (Investment Companies)  Investment companies have a favorable tax situation  Pay no federal taxes on income generated by their security holdings  But only if their earnings flow through to their customers 16-8

Mutual Funds (Investment Companies)  Open-end investment companies, or mutual funds  Funds that buy back (redeem) their shares any time the investor wishes  Sell shares in any quantity demanded  The price of each open-end company share  Equal to the net asset value of the fund  NAV is the difference between the values of its assets and liabilities divided by the volume of shares issued 16-9

Mutual Funds (Investment Companies)  Closed-end investment companies  Sell only a specific number of ownership shares  Usually trade on an exchange  Often offer “double discounts”  Discounted prices on the stocks they hold  Discounted share prices to buy into the fund itself 16-10

Mutual Funds (Investment Companies) Number of Mutual Funds and Their Financial Assets (Open-End Investment Companies) 16-11

Mutual Funds (Investment Companies)  Investment companies adopt many goals  Growth funds invest mainly in common stocks offering strong growth potential to achieve long-term capital appreciation  Income funds typically purchase stocks and bonds paying high dividends and interest to gain current income  Balanced funds acquire bonds, preferred stock, and common stock that offer both capital gains (growth) and current income 16-12

Mutual Funds (Investment Companies)  The investment strategies of many funds appear to be changing  Greater use of derivatives  Futures  Options  Swaps  Various uses  Improve returns  Track indicies  Greater diversification 16-13

Mutual Funds (Investment Companies)  It is not clear if mutual funds hold a significant returns advantage over other investors  With the possible exception of index funds  These companies may roll over their portfolios too rapidly  This runs up the cost of managing the fund and reduces earnings 16-14

Mutual Funds (Investment Companies)  There has been evidence that the managers of several prominent funds had engaged in illegal practices  Late trading  Market timing  Resulting in widespread calls for changes  New legislation  Tighter regulation  Greater disclosure 16-15

Pension Funds  Pension funds protect individuals and families against loss of income  In their retirement years  Allowing workers to set aside and invest a portion of their current income 16-16

Pension Funds  Defined benefit plans  Promise a specific monthly or annual payment to workers  When they retire  Based upon the size of their salary  Also based on their length of employment  Such programs have the advantage of guaranteed income  An employee who leaves early or is dismissed before retirement may get little or nothing 16-17

Pension Funds  Defined contribution plans  Specify how much must be contributed  Amount to be received when retirement is reached will vary  Depending upon the amount saved  Also depending on the returns earned  The funds saved belong to the employee, and are portable 16-18

Pension Funds 16-19

Pension Funds  Cash balance plan  Highly controversial  Tend to favor younger employees  May reduce benefits of older workers if converting from a different plan  Employers typically make a hypothetical contribution equal to a percentage of the employee’s annual salary  Credit the employee’s account  Annual interest credit  Based upon a reference interest rate 16-20

Pension Funds  Pension funds are long-term investors  Limited need for liquidity  Incoming cash receipts are known with considerable accuracy  Their cash outflows are not difficult to forecast  The pension fund industry is closely regulated in many of its activities 16-21

Pension Funds Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. *Figures are for the end of the first quarter of

Pension Funds Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. *Figures are for the end of the first quarter of **Less than 0.05 percent

Pension Funds  There appear to be serious problems ahead for pension plans  The rising proportion of pension beneficiaries to working contributors, related to the aging of the population  The increasing cost of maintaining pension programs, especially defined benefit plans  The rising cost of government regulation with respect to reporting requirements and employee rights 16-24

Pension Funds  Subjected to pressures  Market fluctuations and higher operating costs  Led to a gap between promised payments and market value of asset holdings  These gaps have led to changing standards  Move toward recording assets at current market prices  Pushing firms to ‘fix’ underfunded plans 16-25

Pension Funds  Partially due to the pension fund problems, the pension insurance agency created by the U.S. Congress in 1974 – the Pension Benefit Guaranty Corporation (known as PBGC or, more popularly, as “Penny Benny”) – has recently reported sharply rising budget deficits 16-26

Pension Funds  These deficit are driven by increasing numbers of abandoned pension plans  More corporations dumping their plans on PBGC  Many are very large plans  United Airlines $6.6 billion  Bethlehem Steel $3.7 billion  Among others 16-27

Pension Funds  Currently Penny Benny still insures the retirement plans of over 40 million people  The deficit in 2005 was $23 billion  Cannot continue to lose money at this rate  Might raise rates or lower benefits  Might turn to Congress  In 2006, FASB ruled companies must list their pension surplus/deficit on their balance sheet 16-28

Life Insurance Companies  Life insurance companies  Offer their customers a hedge against the risk of earnings losses  Policyholders receive risk protection in return for their payment of policy premiums  Funds to cover claims and expenses are provided by earnings from their investments 16-29

Life Insurance Companies  Life insurers have branched out from traditional policies  Health insurance  Annuity plans  Many are combination policies  Financial protection against death, disability, illness, and retirement  Savings plans to help the policyholder prepare for some important future financial need 16-30

The Principal Kinds of Insurance Policies and Annuity Plans Sold by Many Life Insurance Companies Source: American Council of Life Insurance 16-31

The Principal Kinds of Insurance Policies and Annuity Plans Sold by Many Life Insurance Companies Source: American Council of Life Insurance 16-32

Life Insurance Companies  The insurance business is founded upon the law of large numbers  A risk that is not predictable for one person can be forecast with reasonable accuracy for a sufficiently large group  Life insurers invest the bulk of their funds in long-term securities to pursue their strategy  Income certainty  Safety of principal 16-33

Life Insurance Companies

Life Insurance Companies  Life insurer income  Primarily from premium receipts from sales of policies  Annual net income from investments averages only about a third of premium receipts  The expectations for income  Roughly break even from its insurance underwriting operations  Earning its profits from its investment income 16-35

Life Insurance Companies  Life insurance structure  The majority of the approximately 1,600 U.S. life insurance companies are stockholder-owned corporations  The rest are mutuals  The population of insurance companies reached a high of almost 2,350 in 1988  Has been falling ever since  Has been converging with other financial institutions to form huge multi-product businesses 16-36

Life Insurance Companies  Life insurers are under increasing pressure to develop new services  Universal and adjustable life insurance  Variable premium and variable life insurance  Mutual funds  Tax shelters  Venture capital loans  Guaranteed investment contracts  Corporate cash management systems  Deferred annuities 16-37

Property-Casualty (P/C) Insurance Companies  Property-casualty (P/C) insurers  Offer protection against events  Fire  Theft  Bad weather  Negligence that result in injury  Traditional P/C insurance covers automobile, fire, marine, personal liability, and property  Many have branched into health and medical insurance 16-38

Property-Casualty (P/C) Insurance Companies  P/C industry structure  There are about 3,000 P/C companies in the U.S.  About three quarters are stockholder-owned  The rest are mutual companies  P/C insurance is a riskier business than life insurance  P/C claims are less predictable  Inflation has a potent impact  The P/C risk patterns appear to be changing  A rapid rise in product liability claims 16-39

Property-Casualty (P/C) Insurance Companies  To reduce risk  More P/C companies have become multi- line companies  Diversifying into many different insurance lines  Increasing litigation  Reduce the risk from any single line  Growth in the reinsurance market  Some specialize in a single line but diversify internationally  New innovations like weather derivatives 16-40

Property-Casualty (P/C) Insurance Companies 16-41

Property-Casualty (P/C) Insurance Companies  Like life insurance firms  P/C insurers plan to roughly break even on their insurance product lines  Earn most of their net return from investments  Achieving the break-even point is difficult  P/C insurers have experienced billions of dollars in underwriting losses in recent years  Increasing competition from international firms and domestic captive subsidiaries 16-42

Property-Casualty (P/C) Insurance Companies  P/C earnings and sales  Reflect the ups and downs of the business cycle  Inflation pushes up the cost of claims  Intense competition holds premium rates down  To improve their future situation  Must become more innovative in developing new services  Eliminate services that generate losses  Must reduce operating costs 16-43

Finance Companies  Finance companies grant credit to businesses and consumers for a wide variety of purposes  Purchase of business equipment  Automobiles  Vacations  Home appliances  Sometimes called department stores of consumer and business credit 16-44

Finance Companies  Consumer finance companies make personal cash loans to individuals  Home equity loans  Loans to purchase of passenger cars  Loans for home appliances  Sales finance companies make indirect loans by purchasing installment paper from dealers selling consumer durables  Commercial finance companies focus mainly on extending credit to businesses 16-45

Finance Companies 16-46

Finance Companies  Finance companies are heavy users of debt in financing their operations  Can choose long-term or short-term financing  Choose strategically based on the term structure of interest rates  Declining number of finance companies  Their average size has grown considerably  Top 20 firms hold 75% of all receivables  There has been growth in ‘fringe banks’ (pawnshops, rent-to-own, title loan, etc.) 16-47

Investment Banks  Investment banks  Raise funds for and provide financial advice to corporations and government agencies  They underwrite new offerings of financial instruments  Purchasing them from the original issuer  Placing them in the hands of buyers  Hopefully at a higher price than that paid to the issuer 16-48

Investment Banks  Investment banks offer diverse services so they are not dependent on security underwriting alone  Give advice on corporate mergers and acquisitions  Trade actively  Commodities  Foreign currencies  Debt and equity instruments  Manage assets  Set up hedge funds 16-49

Investment Banks  Many investment banks have been absorbed in recent years by commercial banking companies  In the wake of the repeal of the Glass- Steagall Act of 1933  The amalgamation of commercial and investment banking opens up a wider menu of services 16-50

Other Financial Institutions  Security brokers bring buyers and sellers together and facilitate the exchange of assets  Security dealers “take a position of risk” in securities. They trade in securities with the expectation of earning a profitable spread  Venture capital firms provide long-term capital financing for new businesses and rapidly emerging companies 16-51

Other Financial Institutions  Mortgage banks work with other businesses on real estate development projects and sell the resulting loan instruments to other investors  Real estate investment trusts (REITs) fund commercial and residential real estate projects  Leasing companies purchase business equipment and other assets and then lease them in return for rental fees 16-52

Trends Affecting All Financial Institutions Today  There are several major trends affecting virtually all financial institutions today  Increasing cost pressures  Consolidation  Service diversification and homogenization  Convergence  Technological revolution  Global competition  Regulatory cooperation and harmonization  Deregulation 16-53

Markets on the Net  A.M. Best Company at  Allstate Insurance at allstate.com allstate.com  American Council of Life Insurers at  Careers in Finance at careers-in- finance.com careers-in- finance.comcareers-in- finance.com  Equipment Leasing and Finance Association at  Fidelity Investments at

Markets on the Net  Financial Times at  FINRA at apps.finra.org/Investor_Information/EA/1/mfetf. aspx apps.finra.org/Investor_Information/EA/1/mfetf. aspx apps.finra.org/Investor_Information/EA/1/mfetf. aspx  Franklin Templeton Investments at  GE Capital at gecapital.com gecapital.com  Insurance Information Institute at  International Foundation of Employee Benefit Plans at

Markets on the Net  Investment Company Institute at  JP Morgan Chase at  Lloyds of London at  Metlife Insurance at  Morgan Stanley at  Morningstar at

Markets on the Net  Mortgage Bankers Association of America at  Mutual Fund Investor Center at mfea.com mfea.com  Mutual Fund Research Newsletter at funds-newsletter.com funds-newsletter.com  National Association of Real Estate Investment Trusts at  National Venture Capital Association at

Markets on the Net  PayDay Loan Consumer Information at  Pension Benefit Guaranty Corporation at  Plunkett Research Ltd. at plunkettresearch.com plunkettresearch.com  Prudential Insurance at  Risk and Insurance Magazine at

Markets on the Net  State Farm Insurance at  The Free Dictionary at financial- dictionary.thefreedictionary.com financial- dictionary.thefreedictionary.comfinancial- dictionary.thefreedictionary.com  U.S. Business Reporter at activemedia- guide.com activemedia- guide.comactivemedia- guide.com  Pension and Investments Newsletter at  Securities and Exchange Commission at  Vanguard Group at vanguard.com vanguard.com 16-59

Chapter Review  Introduction  Mutual funds (investment companies)  The background of investment companies  Tax and regulatory status of the industry  Open-end and closed-end investment companies  Goals and earnings of investment companies  Scandal envelopes the mutual fund industry 16-60

Chapter Review  Pension funds  Growth of pension funds  Investment strategies of pension funds  Pension fund assets  Factors Affecting the future growth of pension funds 16-61

Chapter Review  Life insurance companies  The insurance principle  Investments of life insurance companies  Sources of life insurance company funds  Structure and growth of the life insurance industry  New services 16-62

Chapter Review  Property-Casualty (P/C) insurance companies  Makeup of the P/C insurance industry  Changing risk patterns in property/liability coverage  Investments by P/C companies  Sources of income  Business cycles, inflation, and competition 16-63

Chapter Review  Finance companies  Different finance companies for different purposes  Growth of finance companies  Methods of industry financing  Recent changes in the character of the finance company Industry 16-64

Chapter Review  Investment banks  The underwriting function of investment banks  Other investment banking services  The convergence of commercial and investment banking  Other financial institutions  Trends affecting all financial institutions today 16-65